Australian superannuation funds are finding fine-tuning their international equities allocations a challenging task but, as Damon Taylor writes, those that get the settings right seem likely to deliver significant returns.
With significant uncertainty and recession in a number of offshore economies, global equities are an interesting topic of conversation within the super industry.
In giving investors access to industries that are not available within Australia, global equities always been a good portfolio diversifier — but economic turmoil can give pause to even the steadiest investor.
Giving an insight into how global equities had fared over the last 12 months, Perennial Investment Partners head of international equities Clay Carter said that up until November of last year, markets had been acting reasonably positively.
“Your so-called emerging markets started rolling over in October/November due to concerns about higher interest rates and inflation and that’s pretty much continued through into 2011,” he said.
“Now if you look at what markets have done year-to-date, your so-called developed markets, like the US, UK, and Europe, have done okay; whereas the emerging markets of India, Brazil and China have been lagging.
“What we’ve found is that markets have become a lot more difficult — not necessarily volatile — but there are a number of issues that investors are dealing with on a day-to-day basis at the moment,” Carter continued.
“One example would be the ongoing drama in Greece, but then there’s also the increasing number of central banks that have had to raise interest rates to staunch their respective countries’ inflationary pressures.”
Yet while he highlighted Greece and rising interest rates as investors’ two main worries, Carter added the state of flux that existed in the Middle East and some of the softer economic data coming out of the US to investors’ list of concerns as well.
“So those are the issues that investors are dealing with, but our sense of it is that things become a bit clearer in the second half,” he said.
“In other words, from now until the end of the year, we see interest rate rises being fewer and farther between. We think inflation has probably peaked in India, China and Brazil. And although the Middle East remains a question mark, it probably has less of a market effect with oil somewhere between US$95 and US$105 per barrel.
“Overall, we’d expect some of the things that have been dogging markets for the last eight months to moderate somewhat going into the second half of the year and that equity returns, particularly in those emerging markets that have lagged, will improve.”
A sudden change of heart
Offering a similar take on recent global equities movement, Aberdeen Asset Management senior investment specialist for international equities, Stuart James, said that up until the last two weeks the world had been increasingly optimistic — particularly about US growth and about a European solution.
“I guess I would say that the world is male — it can only focus on one thing at a time,” he said. “So last year, at one moment it was US growth concerns and then it was concerns about the European situation and then back to US growth.
“And you can really see that in the exchange rate between the US dollar and the Euro last year as that kind of focus switched between the two,” James continued.
“But as we got through to the final quarter of last year, the focus actually began to switch to emerging markets and increasing concerns about inflation and, as a result, people gradually became more optimistic about developed markets and probably slightly more cautious towards emerging markets.
“Yet in the last two weeks, I think that’s changed again and, regrettably, I expect that as we move towards the end of this financial year, we’re probably going to witness a lot more volatility as we continue to digest a faltering US economy and an increasing likelihood of further problems in Europe.”
However, while international markets have consistently seen the returns ball bounce back and forth between developed and emerging markets in recent months, offshore investment has not been without its highlights.
According to Carter, this particular cloud’s silver lining has been strong corporate earnings and that, coupled with the long time horizon of super funds investors, has kept traditional international equities allocations relatively steady.
“Corporate earnings have been good and that’s the one bright spot here,” he said. “And we expect that to continue because at Perennial we don’t so much buy markets as we buy individual stocks.
“Our focus is always the companies behind those stocks and recently they’ve been delivering more than anticipated growth, particularly on the top line, and that’s a function of what’s going on in the global economy.”
Talking specifically about whether overseas market turmoil had been dissuaded super funds from global equities investment, Vanguard chief investment officer Joseph Brennan said that most funds were trying to set an allocation to meet a longer run need and mindset.
“Typically, a fund will have around 20 to 30 per cent of their portfolios allocated internationally, and market volatility in the short run doesn’t really change that,” he said.
“Having said that, institutional investors will often control a separate hedge ratio on their currency exposure as a subset of their overall international allocations, and sometimes they will use prolonged moves in currency relationships to adjust it.”
“So, if anything, where we’ve seen a little bit of movement is through some unwinding of hedging within international equities as the Aussie rallied towards US$1.10,” Brennan continued.
“But there have been no wholesale changes to international portfolio allocations, and we wouldn’t expect them.”
Blurring the lines
Similarly seeing little, if any, movement in global equities allocations, James instead said that the key area of change had been an increasing awareness that allocations on a traditional MSCI-world basis were not the best approach.
“Global equities are still a good diversifier and, on that basis, they’re playing the same role within portfolios — but the problem is that we’ve naturally been very overweight to places like the US and Europe and, traditionally, institutional investors and super funds have been underweight emerging markets,” he said.
“That probably hasn’t worked over recent years, and I think people realise that basing your investment criteria on a backwards-looking benchmark isn’t necessarily going to give you the optimum returns.
“So I think it’s more that the makeup of international exposures that’s changing rather than overall allocations.”
Of course, the largest aspect of any re-examination of international equities allocations is in the market’s traditional terminology.
As outlined by both James and Carter, strength and value has ebbed back and forth between developed and emerging markets for some years, but according to Carter there may be merit in doing away with the terms ‘emerging’ and ‘developed’ altogether.
“In some ways, we’re probably not the best people to make a broad call between emerging and developed markets, simply because we don’t differentiate,” he said.
“We have a universe of roughly 9,000 stocks and we don’t differentiate according to whether they’re so-called ‘EM’ or ‘DM’ or whether the companies or large or small — everything is done on a company by company basis.
“Even the term ‘emerging markets’ is a bit old-fashioned to a number of the more sophisticated institutional investors around the world,” Carter continued.
“It’s a bit redundant, because these so-called emerging markets emerged long ago.
“Even if you look at the MSCI-world, the ‘rest of the world’ portion of that is less than 5 per cent, but if you look at some of the longer term studies, probably 50 to 60 per cent of global GDP is going to come from that 5 per cent and the other 95 per cent is a bit ex-growth with high deficits and various sovereign problems.”
In comparing emerging and developed markets more directly, James said that investors needed to remember that labels could be misleading.
“The big difference between the two is really that structurally, emerging markets simply don’t have the same levels of debt as developed markets,” he said.
“Having said that, I think one thing that investors need to be aware of is that labels can often be very misleading.
“So, for example, often you can be overweight to the UK, and given the UK is rapidly approaching emerging market status — albeit from the wrong direction — on the face of it that would look to be potentially a poor allocation,” James continued.
“But what people forget is that many companies listed in the UK, such as Standard Chartered Bank, which is a UK-listed bank, may have 90 per cent of their revenues from emerging markets.
“The key thing investors need to be more aware of is that we operate in an increasingly global economy and companies themselves are increasingly global — where a company is listed is sometimes pretty irrelevant compared to where its actual revenue exposures are.”
For Carter, it is also significant to note that Korea and Taiwan, two of the largest markets within Morgan Stanley’s emerging markets index, had recently been reclassified as part of the developed world.
“Morgan Stanley, in its wisdom, have probably realised that Korea and Taiwan are not emerging markets,” he said.
“And that’s not surprising because when you go to Korea and Taiwan and you look around, you find yourself saying ‘I’m not in an emerging market here’.
“So I don’t think there’s any doubt that we’re going to see a lot of changes in and around global equities terminology,” Carter continued.
“For investors to say that they want to have a global fund or want to have an EM fund, we think that’s going to be blurred and we also think that people like us who don’t make any distinction is a better way to play the fact that, in truth, the only emerging markets out there are what we call frontier market, which are places like Nigeria and Cambodia, the wild and crazy parts of the world.
“You only have to look at markets like Brazil and India and China — there’s some giant companies with market caps of US$200 billion to US$300 billion and you simply can’t ignore them in a global portfolio.”
The task at hand
Yet while it is obvious that global equities fund managers and investors have a number of challenges before them, the background issue for all fund managers servicing the super industry is the upcoming MySuper environment.
Now, more than ever before, cost is top of mind — and according to James, that fact is something all fund managers are well aware of.
“Obviously MySuper puts a much higher focus on the cost of investing and passive approaches or ETFs have generally been more cost-effective, certainly insomuch as their annual management charges are lower than traditional active fees,” he said.
“So I can see the attractiveness of a more passive or ETF approach gaining in popularity even if we ourselves are, potentially, a victim of that trend given that we’re an active manager.
“However, the thing that I would caution here is that if you take a passive approach, you get market returns and you do get that index approach,” continued James.
“And if you do that, you will be overweight places like the US and Europe and potentially underweight emerging markets which, as I’ve argued, is potentially very short sighted.
“But what I would also say is that as a group of active managers, we’ve probably let ourselves down.”
James said that one of the unpalatable realities of funds management was that many so-called active managers were actually what he would deem ‘closet benchmark-huggers’.
“And by that I mean that they charge active fees but they’re benchmark plus or minus 1 per cent,” he said. “So they deliver passive returns, but at an active fee cost.
“They do it because they’re managing their risk of underperforming,” continued James. “But while it’s true that if you copy the benchmark you can’t underperform it, the flipside is that you can’t outperform it either.”
For his part, Brennan said that prudent fund managers had already put significant thought towards what sort of investment products would be attractive in such an environment and whether their own products would have to be changed in any way to remain attractive.
“As I’m sure is the case for a number of fund managers, we’ve had a lot of discussions on this internally, externally and with individual clients specifically,” he said.
“And in the MySuper protocols and recommendations, though the main focus is on lowering costs, we’ve stood for that for many years.
“So we’re in agreement with much of what’s proposed,” Brennan continued.
“Costs are generally regarded as the biggest headwind to investing, so keeping the headwinds down obviously allows for a better path to your investing goals.”
Looking specifically at active versus passive investment in the global equities space, Brennan said that although indexing was the purest form of low cost investing, the terms ‘active’ and ‘low cost’ were not necessarily mutually exclusive.
“You need to find managers with talent and someone who has a really reliable way of picking stocks,” he said.
“If they’re an active manager who adds value and has a strong team and a repeatable process and you can acquire those services at a low cost, then that will be an asset in any portfolio.”
According to James, the battle lines in any upcoming MySuper environment would be drawn between an understandable demand for passive funds and the ability of active managers to demonstrate value.
“For those truly active managers, where we need to focus is demonstrating our skill and ability to add excess alpha after fees,” he said.
“And I think those managers who can demonstrate that they’re truly active and actually can add enhanced alpha and enhanced returns for investors after fees, I think there will undoubtedly be a place for them in the MySuper world.
“But that is our challenge. I don’t think our enemy is passive funds, I think actually our enemy is those active managers who potentially give the sector as a whole a bad name,” James continued.
“And we need to do a lot of work there to demonstrate there’s a difference between being truly active and simply calling yourself active.”
James said that when it came right down to it, there would always be a difference between value and price.
“Yes, passive funds are much cheaper but you’re going to get a market return,” he said.
“If we can demonstrate that while our fees are higher, the upside outcome is much greater, then it’s worth paying those higher fees. The ball is in our court on this.”
